Optimal Fiscal and Monetary Policy under Sectorial Heterogeneity

Abstract

This paper characterizes optimal fiscal and monetary policy in a new keynesian model with sectorial heterogeneity in price stickiness. In particular, we (i) derive a purely quadratic welfare-based loss function from an approximation of the representative agent's utility function and (ii) provide the optimal target rule for fiscal and monetary policy. Differently from the homogeneous case, the loss function includes sectorial inflation variances instead of aggregate inflation, with weights proportional to the degree of price stickiness; and sectorial output gaps instead of aggregate output gap with equal weight in each sector. Optimal policy implies a very strong positive correlation among sectorial output gaps and some dispersion of sectorial inflation in response to shocks. Larger heterogeneity in price stickiness implies larger impact of shocks on aggregate inflation. Optimal taxes are more responsive in sectors with stickier prices.